Sunday, September 14, 2008

In one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself to Bank of America for roughly $50 billion to avert a deepening financial crisis while another prominent securities firm, Lehman Brothers, hurtled toward liquidation after it failed to find a buyer, people briefed on the deals said.

The humbling moves, which reshape the landscape of American finance, mark the latest chapter in a tumultuous year in which once-proud financial institutions have been brought to their knees as a result of tens of billions of dollars in losses because of bad mortgage finance and real estate investments.

They culminated a weekend of frantic around-the-clock negotiations, as Wall Street bankers huddled in meetings at the behest of Bush administration officials to avoid a downward spiral in the markets stemming from a crisis of confidence.

“My goodness. I’ve been in the business 35 years, and these are the most extraordinary events I‘ve ever seen,” said Peter G. Peterson, co-founder of the private equity firm the Blackstone Group, who was head of Lehman in the 1970s and a secretary of commerce in the Nixon administration.

It remains to be seen whether the sale of Merrill, which was worth more than $100 billion during the last year, and the controlled demise of Lehman will be enough to finally turn the tide in the yearlong financial crisis that has crippled Wall Street. Questions remain about how the market will react Monday, particularly to Lehman’s plan to wind down its trading operations, and whether other companies may still falter, like the American International Group, the large insurer, and Washington Mutual, the nation’s largest savings and loan. Both companies’ stocks fell precipitously last week.

Though the government only a week ago took control of the troubled mortgage finance companies Fannie Mae and Freddie Mac, investors have become increasingly nervous about the difficulties of major financial institutions to recover from their losses.

This is just huge. First, there is the question of what will happen to Merrill's 60,000 employees and Lehman's 25,000 employees--expect Lehman Brothers to lay off their 25,000 employees within the next week. Lehman's stock is now down to $3.76 per share, with a $2,514 billion marketcap. Here is the one year stock chart for Lehman Brothers:

The NY Times reports that the crisis started Friday, when a series of emergency meetings took place at the New York Federal Reserve. Treasury Secretary Henry Paulson told Wall Street Bankers that the government would not bail out Lehman Brothers, and that Wall Street would have to solve its problems. Lehman's shares had dropped last week, as investors were squeamish at the prospect that Lehman Brothers would collapse, pulling out of doing business with the 158-year-old investment bank. Lehman Brothers then started shopping for a buyer. There was speculation that Lehman Brothers would be purchased by Barclays, however, Barclays pulled out of the deal, knowing that the British bank would be taking control of Lehman's $60 billion in soured real estate holdings. With no buyer to bail out Lehman Brothers, the company declared bankruptcy.

Bank of America has struck a $44 billion deal to buy Merrill Lynch, according to two people familiar with the negotiations, a merger that will unite the nation's largest consumer bank with one of its most celebrated investment banking firms.

Both boards have approved the deal and it is now being reviewed by lawyers, the sources said. Bank of America will pay about $29 for each share of Merrill Lynch stock. A formal announcement is expected tomorrow morning.

Bank of America is in a position to buy Merrill Lynch because until now the Charlotte company has been a bit player on Wall Street. Instead it runs the nation's largest retail bank, a business that remains highly profitable. That now gives it the money to go shopping for an investment bank, continuing a long tradition of opportunistic acquisitions.

In buying Merrill Lynch, Bank of America is taking a pass on Lehman Brothers, in which it initially expressed interest. But Lehman is far more troubled and Merrill Lynch offers Bank of America a far more attractive franchise, people familiar with the company's thinking said.

Merrill Lynch's crown jewel is the nation's largest retail brokerage. Bank of America views that business as a good addition to its own consumer financial businesses. The company already was the nation's largest retail bank, credit card company and mortgage lender. Now it will become the nation's largest retail brokerage too. Arguably no other American company sits closer to the heart of the consumer economy.

Bank of America had first considered buying Lehman Brothers, however Lehman had $60 billion in real estate losses. Merrill's real estate write-downs of around $30 billion. I'd say that Bank of America went with Merrill over Lehman due to the lower debt losses. And there is even more interesting details coming out of this deal. The New York Times reports that Bank of America wanted the federal government to take responsibility for the losses on Lehman's "most troubled real-estate assets." In other words, B of A was hoping that the American taxpayer would pick up the tab for Lehman's losses, while the bank would walk away with an investment firm in its business, smelling like a rose. A similar proposal was brought up for Lehman Brothers:

A leading proposal to rescue Lehman would have divided the bank into two entities, a “good bank” and a “bad bank.” Under that scenario, Barclays would have bought the parts of Lehman that have been performing well, while a group of 10 to 15 Wall Street companies would have agreed to absorb losses from the bank’s troubled assets, to two people briefed on the proposal said. Taxpayer money would not have been included in such a deal, they said.

Other Wall Street banks also balked at the deal, unhappy at facing potential losses while Bank of America or Barclays walked away with the potentially profitable part of Lehman at a cheap price.